What Do Ratios Tell You?

General Motors has done $140 billion in revenue over the last 12 months. Its market capitalization is $53 billion. Based off its price-to-sales ratio (0.37), it’s the 9th cheapest stock in the S&P 500. These are facts, but of course there’s a lot more to the story.

When GM reported earnings today, management reduced its 2018 earnings-per-share forecast to $6, down from an expected range of between $6.30 and $6.60. There was a lot going on in this one, between higher commodity costs, which put a $300 million dent in earnings, and tariffs, which aren’t helping either. The Wall Street Journal reported that steel accounts for about 53% of the material in a typical automobile and aluminum accounts for another 11%.

And then there is the fact that the company has a ton of debt. Its market cap is $53 billion, but its enterprise value is $134 billion. At 1.89, its debt-to-equity ratio is fifth highest in the S&P 500, behind only Ford, Goldman, Century Link, and AES.

General Motors has razor thin profit margins in the low single digits. Its future is clouded by the threat of electric vehicles and driverless cars. Add it all up and it is not terribly surprising that this company appears cheap based on traditional financial ratios. Below I show various multiples of the average S&P 500 stock with GM (data from BBRG). Whatever ratio you’re looking at, GM is trading at a steep discount versus other large-cap stocks.

If you’re reading this, you probably know that Facebook plummeted 20% after it reported earnings. You also definitely know that growth has destroyed value for the better part of the last decade. The chart below shows the average 5-year return for the twenty cheapest and 20 most expensive stocks based on various metrics. The 20 companies with the highest price-to-sales ratio, for example, have gained an average of 414% over the last five years, compared with an average gain of just 65% for the 20 companies with the lowest price-to-sales ratio*  It’s possible that we look back at this report as a watershed moment for growth stocks.

Alright, so what’s the point? The point is that there is a lot more to investing than just looking at a few ratios. If you’re going to buy a couple of cheap stocks, or stocks that appear cheap because they have a depressed multiple, understand exactly what you’re doing. You’re saying that the market is wrong, which is of course an assumption very few of us have earned the right to make.

Some investors shy away from “expensive” stocks because they’re trading at an above average multiple. This makes sense in a way, because the market often extrapolates this growth too far out into the future, and if and when growth slows, the air gushes out of the multiple.

An investment in a basket of the highest priced stocks might make for disaster, however, this is where the biggest winners always are. Toby Carlisle told Corey Hoffstein that you could have paid something like 1000 p/e for Walmart at its IPO and had you held until today, you still would have received market returns. The market overpays for the growth of the most expensive stocks, but underpays for the growth of the few that do exceed expectations. Of course, separating the winners from the losers is not an easy game.

A price-to-earnings multiple tells you what investors are currently paying for the most recent twelve months of earnings. It doesn’t tell you what earnings will be in the next twelve months, or what investors will be willing to pay for them. When companies are selling above or below the average, it’s usually for a good reason. There’s no edge in a single ratio. This is very public information. So before you buy or sell based on this, ask yourself what you know that the market doesn’t. Ten times out of nine, the answer is nothing.

*A better way to do this would be to look back five years ago at the cheapest and most expensive stocks and then run these numbers, but I suspect it would tell a similar story. If you feel the need to run these numbers, please feel free to send that over.

 

 

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.